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Seed Weekly - Currency Valuation

We have written many reports on the local currency, as it is an emotive topic that is on the lips of many clients and investors. With the allocation to global assets becoming an ever more important consideration in constructing a properly diversified portfolio, and dramatically relaxed exchange controls that effectively mean that most South Africans aren’t limited in their ability to take assets offshore, it is important not to allocate assets offshore in a haphazard way.

We see the valuation of the currency as part of the decision to taking assets offshore. The other key consideration is the valuation of the assets that are being invested into (i.e. global equity, global property, global bonds, etc).

South Africans have seen a consistent devaluation of the rand over the past four and a bit years and the question is, “how much further can it go?” My mother always taught me that ‘can’ is a very loaded word, and it is with this mind-set that we make our decisions. Theoretically the rand could go to R100/$ (US dollar), and I’m sure that as long as we have higher inflation than the US it will go to that level at some point in the (distant) future! For the purposes of our investment decision making process, however, we typically take a 5 year view and look at a range of probable outcomes.

Going back more than 30 years we have constructed a model, below, that indicates the ‘fair value’ (solid black line) of the rand vs the US dollar using the Purchasing Power Parity (PPP) method (as described in previous reports). Around this fair value we show the actual exchange rate (solid blue line) as well as range of what we consider to be ‘normal’. With the rand recently briefly hitting R14/$ earlier this month, we have now breached what would be considered a normal variation from fair value.

According to this model, fair value to the US dollar is currently R10.36. With South Africa facing structural headwinds, we don’t think that the rand will trade at fair value any time soon, but also agree that investors shouldn’t expect consistent continued depreciation in excess of 5% pa (current inflation differential).

A blow out of 2001 proportions would see the rand trading at over R20/$ in April 2016! As can be seen from the above chart this would require an extremely frightful set of circumstances – but wouldn’t be unprecedented. Should we see the rand strengthening as it did from early 2009 (tail end of the Global Financial Crisis) to early 2011 we’d expect it to trade below R9/$ towards the end of 2017. Naturally these two scenarios are extremely different, but are the bounds within which we operate (rather than worrying what would happen if the rand weakened to R100/$).

Practically, in our local Multi Asset Funds (Seed Flexible and Seed Absolute Return Funds), we have maintained our global allocation near 25%, the Reg 28 (pension fund guidelines) limits. One of the reasons for this decision is that our research indicates that an optimal strategic allocation for investors (saving for retirement in South Africa) to global assets is around 30% – 40%. In this context 25% remains underweight so we’d need global assets (and global currencies versus the rand) to have a much poorer outlook before significantly reducing this allocation. Notwithstanding the above, we will look to use significant further rand weakness to hedge out some of the global currency while retaining exposure to the underlying global equities that are offering much better prospects than local assets.

Seed Weekly - Volatility on the JSE

August saw the much anticipated decline in global equity markets. The selloff was severe across a range of market indices with the MSCI All World index losing 7% in the month, the Dow Jones Industrial Average down 6.5%, and the MSCI China index down 11.7% as examples of the declines experienced.

By comparison the decline in the JSE All Share Index (ALSI) in August of “just” 3.6% was therefore relatively muted. However, since the beginning of May local investors on the JSE have experienced a cumulative price decline of 7.6% and naturally for many this is starting to feel very uncomfortable – especially as the market is barely positive for the year to date. When measured in USD, the ALSI was down a more pronounced 8.3% in August.

By historical comparison purposes, until the beginning of the year from the market decline in 2008/2009, JSE investors have had a relatively smooth upward ride. That is until more recently when the global market prices came under pressure, following the Chinese economic slowdown and currency devaluation, the ongoing Greek crisis and uncertainty with respect to interest rate hikes in the US, etc.

We decided to look back at monthly data on the JSE from the beginning of 1970, specifically the peak to trough declines that investors have experienced. What is very interesting is that in each calendar year since 1970 there has been at least one month of negative returns. In many cases where negative months follow one another, investors have suffered losses of up to 20% and 25% in some years. On average the calendar year losses have been around 14% over this period.

It is exactly because of these very large negative periods, that many investors are dissuaded from investing into riskier ordinary shares. The chart below reflects these calendar year peak to trough declines.

What is interesting to observe is the relatively benign period of downside volatility that we have experienced since the market crash of 2008/2009.

Then, when one moves away from the annual declines and looks at the positives, it is noteworthy that out of the 46 full calendar years, there were only 10 years in which investors’ experienced negative returns. This is reflected in the chart below, which reflects annual total return from the ALSI for each calendar year.

As we know and expect, annual returns are erratic. But the positive years more than made up for the negative periods and the compounded average return from the market since 1970 to 2014 was just over 17.5% per annum. It is exactly because of this relatively high price volatility that investors demand and typically receive an additional return when investing into the ordinary shares of companies.

In conclusion we can say that looking back at history, it is not self-evident when an investor will experience large price declines. However, history does tell us that over time it pays an investor to be investing into risk assets if they can adopt a longer term investment horizon. Also because the ideal entry level is when prices are down and risk tolerance is low, currently it makes sense to have a lower allocation to this risk asset.

Seed Weekly - Thrift

In a recent meeting with a professional client, who earns a very good monthly income and who, already at the age of 47, has no debt and is building up a fairly substantial asset portfolio, I was asked a question which got me thinking about a topic which is not often spoken about and which is definitely not “in vogue” within the realms of financial planning literature. The reason for this thought was a question asked. The question was, “What is a good monthly income for a professional person around my age, because I don’t understand how so many of my colleagues and friends can afford all of their fancy holidays, expensive houses and lavish lifestyles?”

The answer to this question is really quite simple: most of his friends / colleagues can’t afford their lavish lifestyles which they presently “enjoy”.

The fact of the matter is that in this modern age of consumerism and instant gratification, most people have forgotten or don’t implement Thrift in their finances. Now many of the younger readers will be unsure of what Thrift actually means.

THRIFT, as defined by the Oxford Advanced Learners Dictionary is: the quality of using money and other resources carefully and not wastefully.

Thrift is not a great concept for the marketing machines of our retail giants, it is also a very difficult concept to implement when your family is questioning why you can’t afford the overseas trip or new car that your neighbours are going on or bought, which they probably couldn’t really afford either. We are constantly bombarded with messages selling products that we don’t really need, and that we definitely cannot afford, by paying for them with money that we don’t really have!!

Unfortunately, as a financial advisor I often have to deal with the consequences of a lack of Thrift. It is an unfortunate fact of life that many retirees have insufficient funds at retirement and face the prospect of a penniless/ uncomfortable retirement and the hope that their kids will remember how nice they were to them so that their kids can look after them.

Whilst it is true that you cannot “save yourself rich” and most wealthy individuals have grown their wealth through substantial capital injections rather than through wise allocations of their monthly budget, the unfortunate fact is that most people will not have large capital injections to secure their retirement so most mere mortals need to implement “Thrift” in their lives in order to secure a dignified and enjoyable retirement.

To come back to the starting point in this article. Whilst the client I mentioned is paid an hourly rate and has very little prospect of capital injections securing his retirement, because he has implemented ‘Thrift” in his financial planning, he will be in a financial position to retire very comfortably.

Seed Weekly - Investment Greats – Carl Icahn

Investment Greats – Carl Icahn

Carl Icahn, the well-known US shareholder activist, grew up in a middle-class family in Queens, New York City. He is the founder and majority shareholder of Icahn Enterprises, a diversified conglomerate holding company based in New York.

After school he received a scholarship to attended Princeton University, graduating with a degree in philosophy. A few years later he took an entry level stockbroker's job in New York. Eventually he bought a seat on the New York Stock Exchange and began his finance career by mostly trading options. Icahn soon grew into a shareholder activist and began using his ownership positions in publicly held companies to force changes to increase the value of his shares.

Icahn is probably most famous for what is called the "Icahn Lift." This is the Wall Street catchphrase that describes the upward bounce in a company's stock price that typically happens when he starts buying the stock of a company he believes is poorly managed.

His strategy involves targeting poorly companies with the potential of unlocking value if ran properly. He then accumulates enough of an ownership position to lobby for a position on the company's board of directors. Usually his first demand is to dump the CEO and, oftentimes, to consider breaking up the company into separate parts and selling them off. Known to be intimidating and relentless he often succeeds. "CEOs are paid for doing a terrible job. If the system wasn't so messed up, guys like me wouldn't make this kind of money."

As a shareholder activist, Icahn is known to be a tough negotiator and clever strategist, whose persistence and personality quirks often distract his opponents. Icahn has had many great battles with multiple well known US corporations resulting, most of the time, in significant capital gains for these companies' shareholders. He is known to be ruthless with company management, using his weight to correct the abuses of greedy and/or incompetent corporate management teams.

Renowned investor Wilbur Ross, friend and frequent adversary of Icahn, referred to him as "the most competitive person I know … he's especially good at terrorizing people and wearing down their defences." He's viewed as such a sure-fire money-maker that investment managers typically start buying up the company's stock, which, whether Icahn is successful or not, leaves him with healthy stock price gains. “I make money. Nothing wrong with that. That's what I want to do. That's what I'm here to do. That's what I enjoy."

As a Forbes Top 100 man, Icahn is also a philanthropist especially supporting higher educational facilities. He has been the recipient of a number of civic awards for his work and contributions to public health, medical research and education charities in the New York area. In 2010, Icahn joined the Giving Pledge list, pledging to give away more than half his fortune.